Equity incentive packages cross-border: structures and strategies

Horacio Vianello
Vianello Law, Buenos Aires

Report on the joint session of the Closely Held and Growing Business Enterprises Committee, the Professional Ethics Committee and the Taxes Committee at the IBA Annual Conference in Rome

Thursday 11 October 2018

Session Co-Chairs
Niklas Schmidt Wolf Theiss, Vienna
Martin Müller Pestalozzi, Zurich

Giulia Bianchi Frangipane BonelliErede, Milan
Elena Kim Minter Ellison Rudd Watts, Auckland
Barbara Koch-Schulte P+P Pöllath + Partners, Munich
Mahesh Varia Travers Smith, London
Gian Luca Grondona Salini Impregilo

Purpose and forms of equity incentive plans

One of the main purposes of having an equity incentive plan (EIP) is to align the interests of the executives and shareholders. Another important purpose is to ensure the retention of the executives participating in the EIP. In this respect, it was noted that for some executives in midcap companies, it makes a difference to be shareholder together with, for example, family owners, even if the percentage of the shareholding is relatively small. Finally, an EIP may be a key element in transition or succession processes, especially when external managers take over for the first time.

When structuring an EIP, careful consideration should be given to the tax treatment thereof in the hands of the executives and the company. In addition, whether it is affordable for the relevant executives to make an investment in the company through the EIP should be considered.

Stock options


Under a stock option plan, the executives subscribe for option rights over existing shares in the company or shares to be newly issued upon the exercise of the option rights. These option rights are assigned at the grant date and exercisable at the exercise date, subject to good and bad leaver provisions, after a vesting period. The option rights provide for financial terms and conditions that determine at which price the option over the shares in the company can be exercised. Typically, the company is the entity employing the executives, but the option rights may also be granted in respect of shares higher in the corporate chain, for example, the listed holding company that heads the group of which the company forms part.

In the case of multinationals, typically an EIP provides the same terms and conditions for all employees, irrespective of the jurisdiction where they are located. Obviously, this creates harmonisation issues, which are typically mitigated by providing for certain exceptions to adhere to local regulatory requirements or tax rules through a deed of adherence to the EIP.

The EIP typically contains detailed rules regarding monetisation events, including tag along and drag along rights for the executives in the case of an exit through a private sale or initial public offering of the company.

The EIP would also contain detailed good and bad leaver provisions that determine how the option rights of an executive are settled in the event of redundancy, dismissal, retirement, death or permanent disability of the relevant executive.

(Dis)advantages for the company

From the perspective of the company, the main advantages include the retention of the executives, and the alignment of interest of the executives and shareholders. Furthermore, stock options are relatively flexible in that they may be made conditional on the individual performance of the executives, the company's performance and so on.

A disadvantage is that if the fair market value of the underlying shares has substantially decreased at the exercise date, an executive will be unlikely to exercise the options (as they would then likely be out of the money). Furthermore, the value of stock options may be significantly impaired due to market conditions that are outside the control of the executives. Stock option rights over shares in listed companies are typically subject to extensive regulatory requirements, which could make them more expensive because of the compliance therewith. The exercise and physical settlement of stock option rights may also result in a dilution of the existing shareholders' shareholding in the company and possible conflicts of interests between the interest of the executives and the company.

(Dis)advantages for the executive

From the perspective of the executive, the main advantage is that no initial investment is needed to participate in the EIP. However, there are risks associated with taxation in the hands of the executive of the income derived by it from the stock options (see below).

Tax consequences in selected jurisdictions

The United States tax system allows for the granting, vesting and exercise of stock options without triggering a tax event (incentive stock option). The shares could be sold immediately (eg, in the course of an exit) and the executive would then realise only capital gains at a favourable tax rate. Holding the shares longer may further reduce the tax rate.

The German tax system allows for the granting and vesting of stock options without triggering tax, but levies income tax at the ordinary rate for employment income on the exercise gain (fair market value minus exercise price). The immediate sale of the shares remains tax neutral as long as the acquired shares have not increased in value since the exercise of the option. If the shares are held for a longer time, the gain from the sale of the shares determined by reference to the fair market value at exercise is subject to favourable capital gains tax.

For the company, usually no tax deduction is available. As a result, stock options do not really make sense under, for example, the German tax system because they create a substantial tax burden without any tax benefit. Therefore, instead of a stock option plan, in Germany it makes more sense to set up a virtual option plan (see below).

Restricted stocks


Under restricted stock plans, shares are issued that are subject to ownership restrictions (eg, with respect to voting, ability to sell/transfer and the company's right to forfeit shares), which typically fall away over time or upon achievement of certain milestones. Restricted stock plans may also provide that the shares are themselves issued in tranches over time and/or if and when certain milestones are reached by the executive.

(Dis)advantages for the company

The main advantage is that the executive has skin in the game from the outset (but without handing over unrestricted ownership of stock immediately). Furthermore, the vesting periods ensure the retention of the executive and provide for performance incentives.

The main disadvantage of restricted stocks is that the shareholdings of existing shareholders are diluted upon their issuance, and once the restrictions have fallen away, the executives become minority shareholders with minority shareholder rights (including statutory minimum rights to information, squeeze-out procedures, etc). Clawback of shares also become more difficult.

(Dis)advantages for the executive

The main disadvantage is the initial cash outlay required from the executive to acquire the stock and the absence of optionality (eg, in stock option rights, where the executive has the option to exercise or not). The main advantage for the executive is that it may be entitled to dividends in respect of the restricted stock (if it receives the same shares as the shareholders), and when the ownership restrictions fall away, the executive may participate on the same basis as other shareholders of the company, for example, regarding voting rights.

Tax consequences in selected jurisdictions

Generally, upon the acquisition of shares, the executive may not be considered the beneficial owner of the shares due to restrictions imposed on the rights attached to the shares. In addition, typically dividends in respect of the shares are taxable in the hands of the executive as ordinary income. Another issue is that, upon vesting, the shares may have increased in value compared to the purchase price paid upon grant thereof, which may be qualified as a taxable benefit in the hands of the executive.

Phantom stock and stock appreciation rights


Phantom stocks and stock appreciation rights provide the executives with a right to receive a cash payment at a future date by reference to the increase in value of the shares in the company. They are cash settled (no physical settlement), and typically the EIP is subject to good – and bad – leaver provisions (see above under stock option rights for further details). Typically, cash settlement of the phantom stocks and stock appreciation rights under the EIP is conditional on the satisfaction of individual and/or company performance.

(Dis)advantages for the company

Phantom stocks and stock appreciation rights are easy to explain and implement, and due to their cash settlement, they do not result in a dilution of the shareholdings of the existing shareholders. Furthermore, generally, their implementation does not require an amendment of the articles of association of the company. As they typically do not qualify as securities, they are not subject to regulatory and prospectus requirements. Finally, the cash settlement is typically tax deductible in the hands of the company (see below).

A disadvantage is the obligation to pay in cash rather than in kind, and such a payment is typically subject to wage withholding tax and social security levies.

(Dis)advantages for the executive

Phantom stocks and stock appreciation rights are easy to understand, and their tax treatment is straightforward (same as a regular wage).

The disadvantage is that the cash settlement is typically subject to tax at a higher tax rate than an in-kind settlement under a stock option EIP (capital gains tax rate).

Tax consequences in selected jurisdictions

All virtual or phantom share or option plans are typically subject to ordinary income tax as employment income and subject to wage tax withholding at the level of the company. The cash settlement is typically deductible in the hands of the company.

Straight equity


Under a straight equity EIP, the executive would acquire the same shares as the shareholders.

(Dis)advantages for the company

Although an issue of shares would, in principle, be relatively straightforward, given the required documentation and valuation of the shares to be issued under a straight equity EIP, compared with phantom stock and stock appreciation right EIPs, straight equity EIPs are more complicated to implement. Furthermore, upon issuance of the shares, the executives become (minority) shareholders with (minority) rights (including rights relating to voting, dividends and squeeze-out procedures). As a result, the clawback of straight equity share EIPs is more difficult. In addition, the transferability of the shares needs to be sufficiently restricted under the EIP.

Tax consequences in selected jurisdictions

In the case of acquisition at a value less than the fair market value (non-arm's length), the benefit is usually taxable as ordinary income upon acquisition (depending on the relevant jurisdiction, different valuation guidelines may apply) and subject to wage withholding tax and social security levies.

Furthermore, if the limitations of shareholder rights (eg, voting and administration rights) are too strong, the executive may be considered not to be the (beneficial) shareholder (see the tax treatment of restricted stocks above). This results in taxation of any proceeds as regular wage income.

Upon certain contractual conditions, proceeds from the shares may be considered as regular wage income, if the connection to employment is too close or conditions are not considered to be at arm's length.

Structuring dos and don'ts, and trends

The key dos and don'ts identified by the panel are the following:

  • do: detailed communication with, and information about, the executives;
  • do: consideration of wage tax and social security liabilities;
  • don't: too much complexity;
  • don't: too tight timeframes for set-up;
  • don't: too many participating executives with investment amounts that are too small;
  • don't: not enough focus on the economics of an EIP; and
  • don't: acquisition of capital instruments at below fair market value (not at arm's length) and other tax problems.

Finally, at the wrap-up of the panel, the following trends were identified by the speakers:

  • There is a strong preference to let the executives have skin in the game.
  • However, if a reduction of costs or complexity of an EIP is an important driver, then virtual schemes, such as phantom stocks and stock appreciation rights are the most popular alternative.
  • There is an increased awareness of tax authorities for EIPs; entry valuations and sweet equity are being scrutinised by them.
  • Increasing prices lead to higher economic risks in EIPs.
  • EIPs increasingly offered more widely (not limited to key executives only).
  • EIPs for tier 2 and tier 3 managers are becoming common.
  • Large participant numbers increase the importance of comprehensive arrangements to manage executive shareholders both during and at the end of the EIP.
  • Share ownership more attractive due to capital gains tax instead of ordinary income tax treatment.